Ask Dow Theory: Is It Really a Bull?

Transports Need 300 Points Before Confirmation

Dear Bottarelli Research Member,

Just because I remain skeptical of this market doesn’t mean I’m opposed to profiting off it. For example, we just entered into Alaska Air November 40 Calls (ALK KH) for $3.20 and they’re now asking as high as $4.00.

The same goes for our Pharmaceutical HOLDRs November 75 Calls (PPH KO). By adding to this position today, we’ve lowered our cost basis down to $3.50. Any continued strength in this sector, which I feel is certainly in the cards, and we’ll be in the green.

But This is Important: This selective call buying does not come without taking precautions. As we all know, stocks do not move in only one direction. And although I’ve been calling for a sell-off over the last week, every new up-tick just makes the coming sell-off that much more violent.

“But what am I basing my prediction off,” you ask?

Well, the first investing book I ever read was on Dow Theory, which says that the market is in an upward trend if one of its averages (industrial or transportation) advances above a previous important high, and that high is accompanied or followed by a similar advance in the other.

It’s because of Dow Theory that the first two tickers on my screen are the Dow Industrials and the Dow Transports. Now here’s the thing. The Dow Industrials have just advanced above a previous high, as seen by the first chart below.

But when you look as the second chart, you’ll notice that the Dow Transports have not yet followed up by advancing above a previous high of their own. In fact, they still need to rally 300 points before confirming that we’re indeed in a bull market.

According to Dow Theory, the inability for the Transports to set a new high means that any bull market has not yet been confirmed. Now mind you, if the Dow Transports rally 300 points and set a new high, I’ll chance my stance. But until that happens, I’d like to be cautiously bearish by holding selective calls alongside selective puts.

To be honest, this “Balancing Act” is doing a good job of keeping us safe no matter what the market throws our way. As I mentioned above, the PPH November 75 Calls (PPH KO) and the ALK November 40 Calls (ALK KH) are advancing nicely, with ALK setting a new 52-week high, as I predicted earlier today.

On the put side, MNST and OSTK are each down today, which is nice to see when the markets are making such a strong advance. This bodes well for our MNST November 40 Puts (BSQ WH) and our OSTK November 20 Puts (QKT WD). Plus, even thought SBUX is up today, it’s certainly not a strong upside move, which makes me comfortable holding the SBUX November 37.5 Puts (SQX WU). The only concerning put position we have is the RIG November 65 Puts (RIG WM), and looking at the recent trends in the oil sector (where an up day is followed directly by a down day) we should see a turnaround if we can maintain the position until tomorrow.

*Trading Note: Do not confuse Dow Theory with the Skirt Length Theory, which is an old CBOE tale that says that shorter skirts tend to appear in times when consumer confidence and excitement is high, leading to bull markets. In contrast, long skirts are worn in times of fear and general gloom, indicating bear markets. I never believed it and neither should you!

No matter if the markets are up or down tomorrow, we’ll have opportunities to take profits off the table. So until then,

Lock and load!

Sincerely,